Chapter

Introduction To Corporate Finance

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All

Key Concepts and Skills

Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Understand the various types of financial markets
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Chapter Outline
Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation

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Areas of Finance
Money and capital markets: which deals with securities markets and financial institutions. Investments: which focuses on the decisions made by both individuals and institutional investors as they choose securities for their investment portfolios. Financial management, or Business Finance, which involves decisions within a firm.

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Career opportunities in Finance

Director of Federal Reserve Director of Investor relations Director of risk management Capital budgeting manager CEO CFO Small business owner Professor of Fonance Real estate broker Financil alanyst Credit manager Cash manager Loam officer Comptroller Consultant Controller Auditor Urban planner Bank officer Real estate appraiser Investment banker Corporate reporter Financila reporter Business manager Mortgage broker Director of Financila reporting Sales representatives Options trader Corporate model analyst Floor trader Mutual fund manager Pension fund manager Investment counselor Banking analyst Trust officer Underwriter Secretary of Treasury Minister of Finance Stock broker Account executive Treasurer Securities analyst Accountant Financial planner Institutional broker Mortgage banker Economist Portfolio analyst Entrepreneur Consumer Advocate Fund raiser Property manager Insurnace agent Risk manager

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Corporate Finance
Some important questions that are answered using finance
What long-term investments should the firm take on? Where will we get the long-term financing to pay for the investment? How will we manage the everyday financial activities of the firm?

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Role of Finance in a Typical Business Organization

Board of Directors President VP: Sales VP: Finance Treasurer Credit Manager Inventory Manager Capital Budgeting Director VP: Operations

Controller Cost Accounting Financial Accounting Tax Department

Since there are financial implications in virtually all business decisions, non-financial executives must know enough to work these implications into their own specialized analyses

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Financial Manager
Financial managers try to answer some or all of these questions The top financial manager within a firm is usually the Chief Financial Officer (CFO)
Treasurer oversees cash management, credit management, capital expenditures and financial planning Controller oversees taxes, cost accounting, financial accounting and data processing
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Financial Management Decisions

Capital budgeting
What long-term investments or projects should the business take on?

Capital structure
How should we pay for our assets? Should we use debt or equity?

Working capital management

How do we manage the day-to-day finances of the firm?
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Forms of Business Organization

Three major forms in the United States
Sole proprietorship Partnership
General Limited

Corporation
S-Corp Limited liability company

The forms of organizations are distinguished by difference in life, ability to raise capital, and taxation.

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Sole Proprietorship
Advantages
Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income

Disadvantages
Limited to life of owner Equity capital limited to owners personal wealth Unlimited personal liability Difficult to sell ownership interest Limited access to heavy products
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Note: many businesses started out as sole proprietorship and then converted to corporations

Partnership
Advantages
Two or more owners More capital available Relatively easy to start Subject to few regulations Income taxed once as personal income

Disadvantages
Unlimited liability
General partnership Limited partnership

Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership Difficulty to raise capital

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Corporation
Advantages
Limited liability Unlimited life (bankruptcy) Separation of ownership and management Transfer of ownership is easy (liquidity) Easier to raise capital (at what cost)
Value of the corporation is boosted by:

Disadvantages
Separation of ownership and management Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate) Cost of set-up and reporting
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oLimited liability reduces risk exposure, more desirable to investors oEasy access to capital, means more investments can be taken, more growth oLiquidity of shares makes it valuable oSometimes they enjoy tax advantages

Business organizations: summary

Advantages Sole proprietorship
1. 2. 3.

Disadvantages

Minimal startup costs 1. No limited liability Less regulation 2. No perpetual existence Tax advantages if profits are low or 3. Difficult to raise capital losses Minimal startup costs Less regulation Flexible business arrangement Possible tax advantages
1. 2. 3. 4.

Partnership

1. 2. 3. 4.

No limited liability No perpetual existence Difficult to raise capital Complex accounting and taxation rules Greater startup costs Greater ongoing costs Capital taxes in some cities More regulation 1-14

Corporation

1. 2. 3. 4. 5.

Limited liability Perpetual existence Easier to transfer ownership Easier to raise capital Possible tax advantages

1. 2. 3. 4.

Goal Of Financial Management

What should be the goal of a corporation?
Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the companys stock?

Does this mean we should do anything and everything to maximize owner wealth?
What about social goals? Do firms have any responsibilities to society at large? Is stock price maximization good or bad for society? Should firms behave ethically?
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Social Goals of the Corporation

Incentives: Improve company image Boost employees morality Improve public perception View that educated society buys new developed products. Counter arguments: Cant ask one form to bear costs alone Shareholder decides what and to whom benefits should go Goal of maximizing firm value serves society:
Ownership of profitable firm serves society Firm provides quality and quantity products at lowest possible costs Firm provide new technology and new products motivated by profit opportunity, thus creating jobs Firm provides availability and convenience motivated by profit 1-16 opportunity and courteous service

Factors that Affect Stock Price

Projected cash flows to shareholders Timing of the cash flow stream Riskiness of the cash flows

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Basic Valuation Model

CF1 CF 2 CF n Value = + + + 1 2 (1 +k) (1 +k) (1 +k) n n CF t = . t t = (1 +k) 1

To estimate an assets value, one estimates the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate (k) Throughout the course, we discuss how to estimate the inputs and how financial management is used to improve them and thus 1-18 maximize a firms value.

What Can Go Wrong

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Main Critics of Firm Value Maximization

Is it compatible with employee need/objectives Is it possible to maximize value and satisfy customers at the same time? Do stock prices efficiently reflect firm value? Is it possible to maximize both shareholders value and social value?
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The Agency Problem

Agency relationship
Principal hires an agent to represent his/her interest Stockholders (principals) hire managers (agents) to run the company

Agency problem
Conflict of interest between principal and agent:
Shareholders and managers/Shareholders and creditors/Firm and /society/Firm and financial market

Management goals and agency costs

Monitoring costs of the shareholders/Costs of implementing control devices
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Shareholders vs Managers

Agency problem exists whenever there is less than 100% managers ownership Managers are naturally inclined to act in their own best interests:
Relaxed life for management will be partially at expense of shareholder Managers work less actively and efficiently due to limited prosperity LBO

But the following factors affect managerial behavior:

Managerial compensation plans (Stock option, performance shares) Direct intervention by shareholders The threat of firing 1-22 The threat of takeover (Poison pill, green mail)

Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal

Corporate control
The threat of a takeover may result in better management

Other stakeholders
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Shareholders vs Creditors
Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors:
Increasing dividends significantly Taking riskier projects than those agreed to Borrowing more on the same assets

In the long run, such actions will raise the cost of debt and ultimately lower stock price. 1-24

Other Agency Relationships

Financial decisions of the firm can create social costs and benefits. This fact has lead to more regulations as well as investor and customer backlashes. On the financial markets front, managers control the release of information, creating holes in the assumption that markets are efficient. Moreover, profit maximization does not necessarily mean stock price maximization
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Work the Web Example

The Internet provides a wealth of information about individual companies One excellent site is finance.yahoo.com Click on the web surfer to go to the site, choose a company and see what information you can find!

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Financial Markets
Cash flows to the firm Primary vs. secondary markets
Dealer vs. auction markets Listed vs. over-the-counter securities
NYSE NASDAQ

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CF between Firm and FM

Firm issues securities
B A

Financial markets

Firm invests in assets Current assets Fixed assets

Retained CF CF from firm assets

C

Dividends and debt payment

ST debt LT debt Equity shares

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Government

Quick Quiz
What are the three types of financial management decisions and what questions are they designed to answer? What are the three major forms of business organization? What is the goal of financial management? What are agency problems and why do they exist within a corporation? What is the difference between a primary market and a secondary market?
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Chapter

End of Chapter

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All